Like other self-employed people, Realtors are challenged to find appropriate tax-deferred investments. When it comes to deferring taxes, people normally think of retirement accounts like 401(k)s, Keoghs, SEPs, and IRAs. But there’s another way to defer taxes on your investment earnings until you reach retirement age: by purchasing a deferred annuity.

What is an annuity?

An annuity is a contract between a purchaser and an insurance company. All tax-deferred annuities have two phases: an accumulation phase and a distribution or payout phase. “Immediate annuities,” on the other hand, begin the distribution phase immediately, with payments starting right away. During the accumulation phase, your money potentially grows on a tax-deferred basis. In the distribution or “annuitization” phase, funds are paid out in installments over a period of time. Earnings that are generated in your annuity account are then taxed as ordinary income as they are paid out. Withdrawals taken prior to age 59 ½ may be subject to an additional 10 percent IRS penalty tax.

Purchase options

Depending on your risk tolerance, you can purchase either a fixed annuity or a variable annuity. A fixed annuity is similar to a certificate of deposit in that it offers a guaranteed rate of return for a specified period of time. Also, a fixed annuity may include an early withdrawal penalty. However, the tax-deferred status of the earnings generated in a fixed annuity account clearly distinguishes it from a CD. In addition, a CD is insured by the FDIC up to $100,000, while a fixed annuity is not. The fixed annuity guarantees are provided by the issuing insurance company.

The other type of product is a variable annuity. A variable annuity is an investment vehicle specially designed for your long-term investment needs and usually has several different kinds of investment options. It is considered a hybrid product, regulated by both the state securities and insurance divisions. As such, a variable annuity is a contract between a purchaser and an insurance company and broker-dealer, and is sold by prospectus. The prospectus should be read thoroughly before investing as it contains complete information on risks, fees and expenses.

Typically, the investor can choose among investment options (stock, bond and/or money market sub-accounts). Money can be moved into and out of the various investment options as the investor sees fit. This makes it possible to respond easily to changes in your investment objectives. Although a variable annuity offers the potential for higher rates of return than a fixed annuity, it also carries the greater risk inherent in fund investments so that when redeemed, the value may be less than the original amount invested. Like fixed annuities, variable annuities are also subject to early withdrawal penalties and taxes upon distribution.

Purchasing a single-premium annuity is done in a lump sum -- an attractive option for the well-heeled individual who wants to begin experiencing the benefits of tax-deferred accumulation as quickly as possible. Alternatively, a flexible-premium annuity can be chosen if you prefer making payments in a series of installments, or in a less systematic way.

Distribution or payout phase

Keep in mind, some important restrictions apply to withdrawals from annuities. During the accumulation phase of your contract, many products will permit you to withdraw up to a certain percentage of your account annually -- usually 10% for a fixed annuity and 15% for a variable annuity -- without incurring surrender charges.

There are also IRS penalties for early withdrawal that parallel those of other tax favored retirement vehicles. Except in cases of extreme hardship such as death or disability (as defined by the IRS), withdrawals from an annuity taken before the age of 59-1/2 (and in the absence of a contract that has already entered the distribution phase under a lifetime payment arrangement) may trigger a 10% Federal penalty tax on the earnings that are withdrawn. The moral: plan carefully when setting up your annuity and fund it with money that you’re fairly certain you’re not going to need until your contract calls for you to begin receiving payments after you reach age 59-1/2.

Distributions from a deferred annuity can take place in two ways. You can either annuitize (enter the payout phase), or you can take withdrawals from the contract during the accumulation phase of your deferred annuity contract.

During the “payout” phase, you can withdraw your money in a variety of ways. A lifetime annuity guarantees you a certain level of income for the rest of your life -- however long or short that might be. This guarantee is backed by the financial strength of the issuing insurance company. This option appeals to people who are worried about outliving their assets. Like anyone else on a fixed income, though, purchasers of lifetime annuities will find that inflation may reduce their purchasing power. You may want to consider delaying the start of lifetime annuity payments for as long as possible.

Annuity payments also can be set up over a certain period, where the payments will continue for that specified period regardless of whether you live or die. In the event of your death, they will be paid to your beneficiary for the remainder of the period.

Annuities offer many advantages, including flexibility in premium payments, payout options and, above all, the benefits of potentially accumulating tax-deferred earnings. A qualified financial advisor can help you determine whether an annuity is consistent with your financial objectives.